Published 11:47 am, Friday, January 8, 2016

Crude oil has become so cheap it could speed the oil market to a recovery.

U.S. crude plunged on Thursday to a 12-year low, an ominous milestone for Houston’s oil hub, which already has shed thousands of jobs in the 19-month oil downturn.

With crude now fetching less than $34 a barrel, about half the nation’s scattered collection of 400,000 aging, nearly depleted wells may have to be shut in as their product becomes less valuable than their operating costs. Called stripper wells, these produce a negligible amount of oil individually but together account for about a tenth of U.S. output.

“They’ll just get turned off,” said David Pursell, a top researcher at Houston investment bank Tudor, Pickering, Holt & Co. “It’ll get people’s attention.”

If crude prices languish at current levels for a few months, it could trigger a loss of 400,000 to 500,000 barrels a day of U.S. crude production this year, analysts say. That’s roughly the same amount of oil Iran hopes to put back on the market this year once international sanctions are lifted.

In other words, a killing blow to half of the U.S. stripper wells could help counterbalance the Iranian crude that industry stakeholders believe will be the world’s largest source of increased supply this year.

Idle stripper wells also could amplify a decline in domestic oil production that’s already taking place. In the U.S. Lower 48, American drillers are putting out 450,000 barrels a day less than last April, when the nation’s production peaked at its highest point since 1970.

U.S. oil output growth outside of Alaska was 20 percent to 25 percent a year from 2012 to 2014 as technology advances boosted production from dense shale formations. As of October, production had grown only 1 percent from a year before.

Production growth is falling because at current prices, it costs an average $19 a barrel more to bring up crude than it’s worth. In a report this week, Goldman Sachs said many U.S. drillers are reaching the point where they will have to restructure. The financial firm projected that banks this spring will cut sharply the amount of money oil companies can borrow and that 8 percent of U.S. oil explorers will go into bankruptcy by year-end. Goldman said lenders could lower shale drillers’ borrowing bases by 14 percent to 30 percent during a semiannual review that begins in April.

Not covering costs

Shale drillers aren’t even close to generating cash flow that covers their costs, and their cost to borrow funds has climbed, said Bill Herbert, a top analyst at Houston investment bank Simmons & Company International.

Declining production eventually will cut into an international oversupply of oil and push prices up.

“The stripper wells are part of it, but the broader narrative is that the rebalancing is happening, it’s just that the market doesn’t care,” Herbert said. “The big wild card right now is the global economy.”

Huge amount stored

At the moment, traders are fixated on the massive amount of oil stored in tanks in the U.S., Europe and Asia, and prices probably won’t rise until a big portion of that is cleared out. That inventory focus was apparent this week when crude prices skidded amid fears that China’s slowing economy wouldn’t demand enough crude to drain those inventories.

Traders largely focused on China’s slowdown and crashing financial markets, shrugging off a rising conflict between Saudi Arabia and Iran that has the potential to disrupt crude supplies.

“People are concerned this will spread around the world to have an even bigger effect on oil demand,” said Andy Lipow, president of Houston’s Lipow Oil Associates.

On Thursday, U.S. benchmark West Texas Intermediate crude sank 70 cents to $33.27 a barrel on the New York Mercantile Exchange, its lowest settlement since 2004. Brent, the global benchmark, fell 48 cents to $33.75 a barrel on the ICE Futures Europe.

A sharp supply drop?

Stripper wells could play a key role in shrinking supplies sharply enough that inventories can decline later this year. Energy research firm Wood Mackenzie has previously estimated oil production outside the Organization of the Petroleum Exporting Countries will drop by 700,000 barrels a day this year, with the bulk of that decline coming from U.S. shale plays in Texas and North Dakota.

But if crude prices hover below $35 a barrel for long, the world could lose 1 million barrels a day later this year, which could go a long way to easing the global oversupply, said R.T. Dukes, a senior analyst at Wood Mackenzie.

“That will help bring the market back into balance a little bit quicker,” Dukes said. “Stripper wells do help provide a physical floor for crude prices.”

Tudor Pickering estimates at current prices the average stripper well, which produces 2.5 barrels a day, brings in $1,800 a month but costs $2,000 a month to operate because of the cost of transporting the oil, electricity, pumps and disposing of water that comes up with the oil. Some 143,000 of those stripper wells are in Texas, with the rest in California, Oklahoma, Ohio, Kansas, Kentucky and other states.

“Iran and other Middle Eastern volumes aren’t going to outstrip the declines in non-OPEC and the demand growth that we expect this year,” Dukes added. “You go from that oversupply to a market that begins to teeter on the undersupplied side in less than a year from now.